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posted by efa 080319, 10.00 am GMT. Breakfast time letter, 6.00 am GMT byinfo@rgemonitor.com. Good morning! What a difference a few days make. Starting with the rescue of Bear Stearns over the weekend to the creation of a new discount window-like lending facility for primary dealers, the Federal Reserve has been engaged in a historical effort to fend off every real fear of a financial system meltdown. Better than expected Q1 earnings reports by peer banks, Lehman Brothers and Goldman Sachs on Tuesday took a lot of the pressure off the markets for the day, while the 75bps Fed fund rate cut to 2.25% (2.50% discount rate) was fully priced in. See our related coverage: “JPMorgan Agrees To Buy Bear Stearns: The Beginning of a Japan-Style ‘Convoy’ System?” and “Overview of Fed’s New Lending Facilities: Needs More to Be Done?” (…) At this point, the distinction between liquidity and solvency is important. While nearly unlimited access to central bank liquidity helps roll over existing liabilities and pay off existing debt, it does nothing to prevent house prices from declining further, borrowers from defaulting on their mortgages and leveraged loans, and it cannot prevent the asset quality deterioration within the collateral pools of CDOs, CLOs, and credit card debt. Eventually, looming writedowns will have to be marked against equity capital. If the equity cushion is insufficient then the financial institution is insolvent. In order to get a sense of the magnitudes: in Q3 the top 5 broker dealers combined equity capital was $144bn, whereas the ratio of illiquid Level 3 financial assets over equity ranged 0.7x – 2.5x.Roudini & C site keeps the lead across the decades, and challenges the Schumpeterian hypothesis on innovation as a temporary window of opportunity. If economics on the web is a Tour de France, Prof. Roudini is Lance Armstrong. When this longrun crisis, more or less the same as today (you know by now we have an Aglietta- Chesnais- Marx- Perez paradigm here at deeprecession), was located in Asia, Paul Krugman recommended rgemonitor.com father site at stern.nyu.edu, with this nice wording: Nouriel Roubini maintains this amazing site. Follow not just the events but the big intellectual debates more or less in real time. Opposite to Roudini and to yesterday, today’s sentiment in the media and Wall Street (a messy coupling), not in Main Street, is that we had luck and escaped the much feared Bear Stearns domino effect. With no evident candidate to play JP Morgan Chase role next time. Although the latter has won a super deal, even bought separately and unconditionally the nicer HQs, Madison Avenue building for $1.1 bn (see March 15 here). We cannot imagine anything more fragile than today’s sentiment.

FT today: paper

p.1: Fed cuts rates to 2,25%. Goldman Sachs ad Lehman lift gloom. “I think we feel better about our liquidity than we ever have” said Erin Callan, Lehman’s CFO. She added that the banks had not seen any erosion in confidence on the part of lenders or trading counterparties. “The past two days gave us a great chance to test those relationships”, she said.Apple considers iTunes shake-up to deliver music access for free. Apple talks with record groups, for a radical change in the business model.p.9, Cracked foundations? A financial crisis spreads slowly into the real economy (Chris Giles). The page focus (Gillian Tett, Krishna Guha) is academic Ben Bernanke’s financial accelerator notion. Two uncertainties: 1) fresh equity filling banks capital holes (Comment: it happened, M. Eastern and Asian SF came to rescue, but this just accelerates the US decline, geopolitical trends laying behind the crisis: it is part of the same over-accumulation → shifting unbalances → bubbles-and-crises process; not a solution); 2) which borrowers will be hit harder: it will not end up only within the financial world, Main Street real-economy borrowers will pay too, as Bernanke’s accelerator takes off. OUR FAQs: “If est. subprime losses of $200bn (Goldman Sachs minimalism) would give rise to a $2,300bn overall credit crunch, will then a still moderate est. of $1,000bn losses (Roudini’s realism) reduce lending by $11,500bn? Or even more, once a downward spiral is engendered (Ken Rogoff, Harvard: from credit crunch to credit collapse)? The bottom line?”p.11, Martin Wolf (reading too much Roudini, but even other Bearish academics): Why today’s hedge fund industry may not survive.OUR ABSTRACT and comments. Dean Foster (Wharton) and Peyton Young (Oxford) model an unregulated financial system: Hedge Fund Wizard and The Hedge Fund Game. Incentive systems fail to align managers and investors aims. The lemons theorem says that such markets with asymmetrical information, attracting the unscrupulous and the unskilled, are likely to disappear (our academic comment – not exactly so; see among others: Kreps, Microeconomics, for a good introduction to lemons. But Wolf’s implicit conclusion holds: you need an agency, a certification, a third party: that is a regulated financial system). Managerial herds behaviour generates cumulative disequilibria, when a low prob. disaster occurs – such as Northern Rock and Bear Stearns (Comment. This argument is really good; it introduces and needs another brand of economic, Santa Fe or econophysics modeling, developed in Italy at Sant’Anna-Normale di Pisa by Giovanni Dosi & C: herd behaviour simulation in financial markets. Their most likely policy implications are again pro-regulation, but with a completely different set of arguments and suggested policies, compared to information asymmetry models. The focus shifts, here, from a simple market failure that can be easily repaired by an “agency”, to a complex financial systems dynamics, far away from both equilibrium and social optimum. With no straightaway agency solution: you have to change, redesign the entire system, together with contracts and incentive schemes. Until now we just spoke microeconomics. Add the macro: along Keynes- Kalecki – Minsky lines, e.g., you approach systematically the issue of the health of the financial system that greases the wheels of capitalism – a quote from NYT yesterday, reporting from Wall St.: even operators and rentiers know and feel it on their skin: the time is out of joint, to quote Shakespeare, and Derrida on Marx).

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Ups and downs in financial global markets: Bernanke’s hyper-activism adds chaos to turmoil. Paul Krugman said a few days ago: Greenspan is the one teaching ex cathedra how to close the door, when stables are already empty, and the flock is gone. Bernanke makes the difference: he got Speedy Gonzales and succeeded – in a couple of months – to convince 75% Americans that Roudini as well as radical pessimists have sound bases.Lehman Brothers opened yesterday at -15%, and closed only at -19%. See Slate‘s syntheses of US newspapers, and sing: “You just better start sniffin’ your own rank subjugation jack ’cause it’s just you against your tattered libido, the bank and the mortician, forever man and it wouldn’t be luck if you could get out of life alive”

Knock-knock-knockin’ on heaven’s door (4 times)

TODAY’S PAPERS

Knocking on Lehman’s Door

By Daniel Politi Posted Tuesday, March 18, 2008, at 6:12 AM ET Financial news continues to get top billing as all the papers try to digest the latest news from the Federal Reserve and the markets to figure out how far the current crisis will spread. The New York Times‘ lead story notes that although the stock market didn’t plunge as was widely expected, there were several ups and downs as uncertainty ruled the day on Wall Street. By the end of the day, the Dow Jones Industrial Average closed the day with a 0.2 percent increase, largely due to the strength of J.P. Morgan, which rose due to the widely held belief that it was able to acquire Bear Stearns at a veritable bargain. The Washington Postleads locally, but off-leads news that shares of many of the largest banks and investment firms plummeted yesterday.The Los Angeles Timesleads with a look at how many are wondering whether the Fed is taking on too much risk and for how long it can keep pumping money into the economy in its attempt to save the country from a deep recession without hurting the nation’s overall finances. Over the past few days, many economists have said that the key question now is not whether the country will enter into a recession, but rather how long it will last. Ordinary Americans seem to agree. USA Todayleads with a poll that shows 76 percent of Americans think the country is in a recession. In addition, 79 percent said they’re worried about the possibility of a depression that could last several years. [our red&bold]De(e)pre(ce)ssion so popular, so soon? we didn’t hope so much!

WASHINGTON — More than three in four Americans think the country is in a recession, a USA TODAY/Gallup Poll over the weekend shows, reflecting a crisis of confidence that economists say could make the economy worse.(…)

Seventy-six percent of those polled said the economy is in recession, compared with 22% who said it’s not. Not since September 1992, two months before President George H.W. Bush lost re-election, have so many said the economy was in such bad shape. (…)

Asked whether the nation could slip into a depression lasting several years, 59% said it was likely, and 79% said they were worried about it. A recession is an economic downturn that usually lasts at least six months; a depression is longer, deeper and more broadly dispersed. (…)

Democratic presidential candidates Barack Obama and Hillary Rodham Clinton urged greater action. Obama, campaigning in Pennsylvania, said the economy “is heading toward recession. We probably already are in one.” He said, “We must focus on what we can do to restore the public’s confidence in the market.”

Clinton was more cautious. Calling it a time of “stress and uncertainty,” she said there was “urgency” to continue monetary policies like those taken Sunday. “We are in the soup, and we better get ourselves out of it before the consequences get drastic,” Clinton said in Washington.

Presumptive Republican presidential nominee John McCain was in Iraq Monday. His top economic adviser, Douglas Holtz-Eakin, said McCain has confidence in the Federal Reserve’s action to shore up the nation’s financial system. Although that action may have been necessary, he said, it’s imperative to “ensure that Main Street America does not bail out financial speculators.”

The Fed Goes Deep

By Daniel Politi

Posted Monday, March 17, 2008, at 7:06 AM ET

The New York Times, Washington Post, Los Angeles Times, and USA Todayall lead with, while the Wall Street Journal devotes much of its Page One to, the Federal Reserve announcing a series of moves to try to bring some stability to the increasingly shaky financial markets. Lest these be confused as just one more of the series of measures the Fed has taken in recent months, the papers make clear that this latest action is “dramatic” (WP), “extraordinary” (LAT), and “apparently unprecedented” (NYT). The Fed opened up its lending practices to make more money available to the biggest investment firms on Wall Street, and cut a key interest rate (the so-called discount window) for financial institutions by a quarter of a percentage point. The central bank also announced it would extend a $30 billion credit line to help J.P. Morgan Chase complete the purchase of Bear Stearns for what the WSJ calls “the fire-sale price” of $2 a share.

Specialists say their biggest worry now is not whether the economy is already or will soon be in a recession. Far more fundamental and troubling is the health of the financial system that greases the wheels of capitalism.

“Recessions come and go — that is something investors can deal with,” said Marc D. Stern, chief investment officer at Bessemer Trust, an investment firm in New York. “The bigger issue is, Can our financial system be restored to a sense of normalcy? In recent weeks we have been moving away from that, which is potentially very serious.”

(Investors’ calm)… is unlikely to last long. After all, at a price of about $2 a share, the deal has wiped out Bear shareholders almost completely.

And the Federal Reserve, which initially supported Bear on Friday, is having to pledge $30bn to fund Bear’

s less liquid assets to allow the deal to happen at all.If another broker loses the confidence of investors and counterparties, the Fed will be on the hook again. But, if there is a next time, it is not obvious which of the big banks would ride to the rescue. Their balance sheets are already seriously constrained, and Bear was the smallest of the leading Wall Street firms. MY NOTE: “20bn of exposure are covered through (Fed’s) non-recourse, and only 13bn remained as net exposure to JP Morgan” (JP Morgan)posted by efa, 080818 at 11 pm GMT

March 17, 2008

Regulators must do whatever they can to keep the markets open and operating, and much of that relies upon the confidence of investors. But by offering to backstop firms like Bear, who were the very architects of their own — and the market’s —

current problems, overseers like the Fed undermine a little bit more of that confidence.

While the bail-out of Bear Stearns is still a very young, thus far at any rate I have heard not a single convincing argument for why this financial business should be assisted by the Fed, rather than the ball bearings company in Cleveland, Ohio.

The economists, including Prof Buiter and Nouriel Roubini, generally favour the view that the Fed ought not to have intervened to prop up a non-bank institution and, if it was not able to hold back, should have proceeded straight to nationalisation. Prof Roubini argued this last month and restated it on Friday:

First fully wipe out those shareholders, then fire all the senior management and have the government take over such a bankrupt institution before a penny of public money is wasted in bailing it out.

But I think the different outcomes in the cases of Northern Rock and Bear Stearns at least help to justify the Fed action.

The extraordinary weekend moves came as J.P. Morgan Chase (JPM) sealed a deal to buy Bear Stearns Cos. (BSC) for just $2 a share backed by up to $30 billion borrowed from the Fed. The Fed board gave its approval to that unique funding arrangement, which guarantees JP Morgan against losses from buying Bear.

Posted efa March 16, 11:30 pm GT

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PAY ATTENTION! Very important “old news” here.

Not only finance experts-managers subscribing to Finch: any RGE (no. 1 macroeconomics site) cautious reader already knew, by end of July 2007, that 2 of the big 5 US investment banks were virtually bankrupt: their toxical “residual balances” from securitisation equalled more than half their tangible equity. According to our analysis of Finch-through-RGE data (see our “Banks go bankrupt” page and enclosed data pdf for details) this abnormal ratio toxic interests = 1/2 tangible equity:a) holds for Bear Stearns at least as early as 2004;b) Lehman Brothers joined the risky league in 2006. Bearn Stearns is dead, now is it Lehman Brothers’ turn? Today’s breaking alert opening of rge-monitor main page (red bold added):

Hedges on Level 3 assets (i.e. “short their own instruments”) produced book gains of $750m at Lehman (largest amount among 5 brokers) but Fitch decided that gains from credit spread widening will not be considered in evaluating operating performanceLehman Brothers Obtains $2 Billion Bank Credit Line (Update2)

By Andrew Frye

March 14 (Bloomberg) — Lehman Brothers Holdings Inc. obtained a $2 billion credit line as the investment bank tried to blunt the stock’s worst drop in almost eight years and assure investors the firm isn’t short on cash.

The unsecured, three-year facility from 40 banks replaces an existing credit line, New York-based Lehman said today in a statement. JPMorgan Chase & Co. and Citigroup Inc., also based in New York, led the effort, the firm said. (…)

… it is not clear what JPMorgan CEO Jamie Dimon will do if his company JPMorgan Chase & Co buys Bear; he hates the bank and doesn’t need traders. The likely scenario, sources say, it that he gets rid of most everything except prime brokerage and clearing operations. He also apparently likes the Bear building which is around the corner from the less elegant Chase headquarters.

One big problem is that whoever buys Bear will want to retain some of the talent. However, they are already being offered jobs elsewhere.

In the meantime, the Bear debacle is a huge blow to New York City and its Metro-area economy where most of Bear’s workforce lives. Many will be out of work. Bankers and other execs have lost fortunes since many were paid in Bear stearns stock.

Voyeurist? Watch Wall Street through keyholes! U might find the two highest US and world economic policy authorities, where u wouldn’t have imagined …

Wall Street Journal’s spying eye, captured by Calculated Risk’s monitoring eye:The story discusses how Bear Stearns, JPMorgan and the Fed regulators worked around the clock Thursday night to put together the bailout.

At about 5 a.m. Friday, regulators including New York Fed Chief Timothy Geithner, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson and the Treasury under secretary domestic finance, Robert Steel, convened by conference call. At the end of the call at 7 a.m., the Fed had decided it would offer the loan.

A fascinating story.

And a bitter, sharp comment by (competing? cooperating?) FT-Alphaville blog: at Calculated Risk they missed to anticipate the bankruptcy, so now they try hard to struggle against the irreversibility of the time arrow .., and give you any hints ex post.

Such a nasty, really nasty comment, suggests to me a Methodological Note on economic blogs webs.

Even economic blogs are economic agents, or (better) agencies, of a new sort; therefore they compose, make and unmake beautiful, complex, efficient, redundant and Pandora’s box social webs of cooperation-and-competitionacross them:

– not just a mere replica of social webs amongst the agents behind such agencies; this too, but even more. E.g., Prof. Roudini’s scenarios are diffusing in early 2008, not without resistance, counter-arguments and replies, across blogs.

– I would not be surprised if sometimes cannibalism had to re-emerge, by the law that if you keep watching Wall street tribal cannibalists at work, unwillingly you absorb something.

They’re so complex and multi-faced, the cross-blog flow components of Web2 social networking, that no econophysics’ web rough graph (so nice to look at) can capture their true, full-senses flavours, and crossed regards of the 2nd, 3rd .. Nth order. Much more sophisticated econometric and sociometrics tools, human and social in-depth analysis are required.

You are now watching me, watching C Risk, watching WSJ, watching Bernanke and Paulson (!!!) at unusual early morning job, watching Bear Stearns empty safe: it makes a 5th order – that is, a much longer chain, compared to what Experimental Economics evidence tells us about 2nd-3rd order expectations widely adopted as conventions in financial markets !!! Students and scholars know well that reinforced Nash equilibrium notions, often assume very high-order expectations on other people’s expectations, but in reality we rarely base our strategies going beyond the 4th or 5th order. As common in the current state-of-the-art, cognitivism, experimental economics and psychology come here to help, by correcting unrealistic assumptions emebedded into Games Theory maths.

But are perhaps social networking practices violating these “natural” limits of our social behaviour?

In just one step I cross the 6 or 12 steps separating me from another mind at work? Or do I just complicate simple systems: by reading WSJ in paper I would have avoided unnecessary, redundant steps?

And what about serendipity? it happens on Fondamenta della Misericordia, Cannaregio (today to me, Dario and François Chesnais), or in virtual Misericordiae as well. In such a case, random & redundant walks are creative & productive, namely if one meets Adamo and ends up at La Rivetta.

De(e)pre(ce)ssion view

There are many prospective insolvencies, that will shift and spread over 2008: Bear Sterns is no.1 of a series. A huge amount of losses are hidden on purpose and strategically, in the global finance system including banking, finance, and the “shadow financial system” (as defined in the Roudini’s quotation to follow).

And there is highly asymmetric uncertainty about how such a trillion $ loss is allocated, with unavoidable, necessary and systemic consequences on trust, inter-bank relations, and the M&C available to the whole economy.

As financial global markets sink in a deflationary turmoil, instability is now spreading everywhere, from currencies to commodities first, with obvious inflationary effects making part of the recession-deepening process itself:

“There are other significant shoes that are in the process of dropping on us, and that’s why I think you’re going to see further increases in the commodities across the board, because it’s the safe haven, it’s the inflation haven, the safe haven, the hard asset haven that investors are just running to right now just because they’re scared.”

Finally, at the end of the money K chain, i.e., in the commodity K circulation and value creation domains: a M&C and financial impact is accelerating now (and presumably along all the year 2008, at least) the current global recession – which

(b) is deeply rooted in the 1987-2007 “Minsky’s age” (versus the over-optimist, ever-forgetting theory of just a short run “Minsky’s momentum” or window) of over-accumulation and continuous financial turmoil – see Chesnais 2008, Fin d’un cycle.Carrè rouge- La brèche, no.1; and the recent Aglietta’s works commented and quoted there.

A deep “real economy” recession would in any case roll-on and spread by now, by tracing back I-O, cross-market and cross-country commercial relations and systemic links – even without this acute M&C crisis, but in that case much less deeply and more slowly.

(c) We will go deeper, as far as we can, in understanding the deep recession unravelling, by supplying all the best analytical references and tools we know, in an imminent new static page of this blog: perhaps to be called A DIARY OF THE 2007+ WORLD CRISIS.

BBC: “Bear Stearns has been severely affected by the loss of confidence in credit markets. The company had invested heavily in sub-prime mortgage instruments and other securities which are now seen as highly risky, and which have fallen sharply in value. And it had less capital than its rivals, such as Citigroup and Merrill Lynch, who were also heavily exposed, to plug the gap.”

Roudini comments, with good reasons reported below: I told you 40 days ago (it is an answer to Bulls saying he is Bearish, e.g. Yves Smith, Naked Capitalism: Martin Wolf Reads Too Much Roubini).

Step 9 of the Financial Meltdown: “one or two large and systemically important broker dealers” will “go belly up”

Nouriel Roubini | Mar 14, 2008

In my February 5th piece on 12 Steps to a Financial Disaster I predicted – as Step 9 of the meltdown – that “one or two large and systemically important broker dealers” will “go belly up” and that other members of the “shadow financial system” – i.e. non-bank financial institutions that look like banks in terms of liquidity/rollover risk – will also go bankrupt. As I put it then:

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems – cannot be directly rescued by the central banks in the way that banks can. [bold added]

And today the first one of these large broker dealers – Bear Stearns – in on the verge of bankruptcy. Let us be clear: given its massive exposure to toxic MBS and ABS product Bear Stearns is insolvent; the decision by the NY Fed to try to bail out Bear Stearns would make sense if this firm was only illiquid; the trouble that it is insolvent and thus such attempted bailout is altogether inappropriate. It is true that Bear is a large broker dealer; but its systemic importance is much smaller than that of much larger institutions. The world and financial market can survive if Bear disappears.

NY Fed avoided the obstacle underlined by Prof. Roudini, by triangularizing on JP Morgan: it doesn’t change much, exc. that JP Morgan has now insiders info allowing them to make perhaps the best offer for Bear assets. On Prof. Roudini’s close, we at de(e)pre(ce)ssion are even a bit bearer than he is, if possible: on the liquidation of Bear Stearn’s assets, markets deflation will carry on, etc. We will see.

PS. Hedge funds themselves take their time to read Roudini; financiacapital.com, advisor and a California’s fund general partner, suggests to his clients:

Nouriel Roubini’s Blog – Nouriel Roubini is a professor of economics at the Stern School of Business (NY University), and though sometimes too bearish in our opinion, his views on the various economic data are always worth the time to read.

Empirical and theoretical consequence: the shadow financial system has by now become what is called a critical, self-representing complex system, in system theory: they observe us observing them observing us observing them… .

We formulate expectations upon them, expecting that we … expect them to … because they expect that we … by supposing they expect that … (a long, but finite chain). Suggested reading: Niklas Luhman.

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